College Savings: Coverdell ESA vs. the 529 vs. Coffee Cans in the Backyard

A reader recently asked what I would recommend as far as College Savings are concerned, ask and you shall receive. Note: this information is based only on United States tax laws and programs as it relates to college savings.

For Canadians who came across this page, the basic equivalent to a 529 plan in Canada is an RESP (Registered Education Savings Plan). It is a tax-free account you can start for your child’s post-secondary education, and contributions can be made at any time by anyone.

There are several options with regards to college savings programs and I would recommend all of them over stuffing money in your mattress or putting it in a money market account or CD. That being said there are really only two good options that I would recommend.

Coverdell Education Savings Accounts

In the past this program has been known as an Education IRA but it’s now known as a Savings Account. In a nutshell it’s very similar to a Roth IRA which means that you contribute after tax money into the account and it will grow tax free as long as you only make withdrawals for qualified education related expenses. A supercool aspect of this account is that it’s not just limited to college savings, education expense from Kindergarten to 12th grade also qualifies. Need to get Suzy a new laptop for highschool, Wazaam, ESA money.

Coverdell Guidelines

Coverdell Beneficiaries

You can setup a Coverdell ESA for anyone who is under Age 18 or is a special needs beneficiary.

Contribution Limits

You can contribute a maximum of $2000 annually to a Coverdell Education Savings Account as long as your adjusted gross income is less than $110,000 or $220,000 if filing a joint return. That’s $2000 total, so if your parents for instance want to contribute $100 to a Coverdell ESA they setup at their bank, that means that you can only put in $1900 in your ESA.

Coverdell Education Savings Account Investment Options

This is the strongest reason for establishing an ESA for your child the sheer amount of investment options for your money. Essentially you can choose from thousands of mutual funds and in some cases individual stocks and bonds to invest your students money and not have to be limited to a small subset of investment vehicles.

How to Setup a Coverdell ESA

You can setup a Coverdell ESA at many banks, credit unions or investment firms. Be careful though some will put your money in a IRA type account that will get you a crummy interest rate say 3 or 4%. You want to be able to invest that money in good quality mutual funds. If I was to go pick one right now I’d choose Scottrade they have some of the lowest fees anywhere for just about any investment product and they are just a solid investment company.

529 College Savings Plan

The 529 College Savings Plan has a dizzying array of options and would be my next step after fully funding your Coverdell ESA. Like the ESA your earnings grow tax deferred and money pulled out for qualified educational expenses are tax and penalty free. They are not straightforward by any means and you have to be careful of varying fee structures and specific requirements as they change from state to state. Some of the plans have residency requirements or other limitations. We’ll cover the high level details here and for further information I would recommend some quality time at Savingforcollege.com run by Bankrate for comprehensive information on 529 plans.

529 Guidelines

Every state has some form of 529 plan available but you are not necessarily limited to using your own states plan. They breakdown into two kinds of plans

Savings Plansare similar to a Coverdell ESA and allow you to invest contributions in mutual funds or other investment types usually limited to a few choices setup by the plan administrator. Your contributions will grow based on the performance of the investment option you choose.

Prepaid Tuition is the name given to a plan that will allow you to lock in today’s tuition rates for you children’s future with the thought that the savings will far outstrip the increase in tuition prices.

529 Beneficiaries

There are no age limits imposed by the program so you can setup one for your adult child if you so desire.

Contribution Limits

There are no income limits with a 529 account which is an advantage over the Coverdell. If you are rolling in the greenbacks this might be your only option. Each plan may differ in the amount of money that can be contributed for example a plan my limit total contributions to $200,000. Harvard anyone? But note if you don’t use all the money for education purposes, the earnings may be subject to income tax and early distribution penalties.

How to Setup a 529 College Savings Plan

Depending on which plan you choose you’ll have options of either signing up directly with the plan administrator or through a local broker. Again this depends on the specific plan and there is no common clearinghouse of information.

General Recommendations

If I was to start out saving for my child I’d first save up $2000 to fund a Coverdell ESA for the year invested in a good set of mutual funds. If I wanted to set Johnny up for the Ivy League I’d then setup a 529 plan with a low fee structure and some decent investment options. I originally started saving for my boys with Upromise‘s 529 plan which is linked directly to their Upromise savings. It’s the state of Indiana’s plan but you can set one up if you live anywhere in the US. Morningstar ranks it currently as the 2nd best plan in the U.S. which is definitely something. For future I will be opening Coverdell ESA’s as they were not available when I started saving for them and will also fund our Upromise 529.

Remember, if you are rolling dough, the 529 is still subject to gift tax limits ($13K/person gifted to), but the 529 has a special rule that you can gift up to 5 years in advance, e.g. this year gift $65K and none for next 4 years. If you are married that’s $130K from the two of you.
Also, the Coverdell permits expenses for high school, 529 is just College or higher.
Lastly, the 529 allows for changes in beneficiary, so what the kids don’t use, the grandkids can. A great was to get money out of your estate if that appeals to you.
.-= JoeTaxpayer´s last blog ..New Credit Card Law Starts Today =-.

FYI: Some states offer state income tax credits for contributions into their own 529 plans. For example, I live in Indiana and they offer a 20% credit up to $1,000 for contributions into the IN plan. Of course there are stipulations, but this may entice some people to go for the 529 and get a break on state taxes.
.-= Jason @ Redeeming Riches´s last blog ..Friday Finance Round Up ““ August 21, 2009 =-.

late comment, I know, but with the possibility of the Bush tax cuts expiring this January 2013, we will no longer be able to invest 2000.00. If I understand correctly, the limit will now become 500.00. And if that’s the case, 529 plans all of the sudden begin to look much better.